In business development, people often refer to financial forecasting and financial modeling interchangeably. While there are commonalities between the two, forecasting and modeling are distinct functions.
The tendency to mischaracterize financial forecasting and financial modeling stems from their complementary nature. Both also have similar objectives: gathering information to predict a business's future performance to help stakeholders in a company make critical decisions.
Financial planning & analysis (FP&A) employees create financial forecasts to project revenue and expenses, which then help the business estimate its cash position at a certain period in the future. This may be a standalone role in larger companies, while it is often incorporated into the responsibilities of finance employees in smaller companies.
Once the team has created forecasts, it can use financial modeling tools to simulate the effect of decisions using different scenarios and conditions. In effect, financial modeling helps the finance department fully understand the impact of decisions on future business performance.
Increasingly, tools are making it easier for stakeholders outside of FP&A to create models in areas such as product development, marketing, human resources and the supply chain.
- Financial forecasting is the process of projecting how a business will perform during a future reporting period.
- Financial modeling is the process of gathering information from forecasts and other data, then simulating discrete scenarios to analyze what impact they might have on the company’s financial health.
- Business planning teams often rely on business forecasts and models together to develop more granular forecasts, create budgets, assess capital needs and analyze investments.
What Is Financial Forecasting?
Financial forecasting is an essential function within business planning, budgeting and operations management. Business leaders, investors and creditors review these forecasts to assess projected revenues and expenses so they can estimate a company’s cash flow throughout the accounting period. A financial forecast considers trends in external and internal historical data and projects those trends in order to provide decision-makers with information about how the financial performance of the company is likely to be at some point in the future.
A company’s key stakeholders rely on financial forecasts to make decisions around purchasing, hiring and capital expenditures. Managers need financial forecasts to create budgets.
In most cases, companies issue financial forecasts for the upcoming quarter or year. Often, forecasts will cover multiple reporting periods. Companies sometimes issue revised forecasts during a reporting period if they determine sales are trending in a different direction due to unforeseen factors.
Why Is Forecasting Important?
Forecasting is an important step at the outset of each accounting period because it establishes how the business will maintain the cash flow needed to cover its financial liabilities. It also provides data that leaders rely on when creating budgets. Likewise, financial forecasts weigh heavily in financial decisions about a major capital expense, hiring or other substantial investments. A valuable forecast indicates the resources needed, when they’re needed and how you’re going to pay for these resources.
A business might include the predictions of its forecasts on pro forma financial statements, which are like standard financial statements, except they show results for the past and future based on hypothetical conditions. Pro forma statements are often given to investors or creditors, who will take them into account as they decide whether to give the company additional funding. They’re also used to illustrate the impact of a recent or planned acquisition or merger.
Financial forecasts are also critical for anyone creating a new business plan.
What Are the Methods of Financial Forecasting?
Finance teams create forecasts by gathering any available data that could improve their projections, including sales, labor expenses, cost of materials and more. Much of that information comes from prior reporting periods, but finance employees also consider internal and external information that could have an impact on expenses or revenues. Depending on the nature of the business, external data could include economic or industry reports and other variable factors, such as extreme weather events and geopolitical influences. Examining factors that could surface in the future is also important in accurately projecting revenues and expenses.
The finance department has historically created simple forecasts in Excel spreadsheets, and many still do. But now that employees have access to more data and tools than ever before, many companies are using Enterprise Resource Planning (ERP) modules for forecasting or dedicated software that integrates forecasting, budgeting and modeling.
There are four different financial forecasting methods:
- Straight-line Method: Considered the simplest approach to forecasting, planners use historical figures and trends to estimate revenue growth. Financial forecasts using this method typically have defined beginning and end dates. Financial analysts can use spreadsheets to create these forecasts, though a tool designed for forecasting makes it easier to respond in a rapidly changing market.
- Moving Average: Moving averages use repeated forecasts to develop estimates based on past performance and the patterns within. The most common moving average models are for three months and five months out.
Simple Linear Regression/Multiple Linear Regression: This is a method of analyzing the relationship between a dependent and independent variable. Using the simple linear regression method, if the trend line for sales (x-axis) and profits (y-axis) rises, then all is well for the company and margins are strong. If the trend line falls because sales are up but profits are down, something is wrong; perhaps there are rising supply costs or narrow margins.
A linear regression shows the changes to the dependent variable using a graph line, indicating a trend. identify underlying patterns which you can then use to evaluate common financial metrics such as revenues, profits, sales growth and stock prices. A rising moving average indicates an uptrend, whereas a falling moving average points to a downtrend. In more complex scenarios, companies may use a multiple linear regression to look at multiple independent variable outcomes. They can then analyze how those factors will affect business results.
- Time Series: A time series method uses numbers from specific time intervals, like the last several months, to predict future performance in the short term. For example, a distributor may look at revenue numbers and monthly growth over the past three months to forecast results for the upcoming month, or an energy company could use it to predict oil prices over the next two months.
What Is Financial Modeling
While forecasting provides the base estimates of a company’s performance during a given accounting period, modeling allows analysts to use those forecasts to assess how various potential scenarios might impact near- and long-term performance. Financial modeling tools let analysts manipulate their forecasts as much as they choose to assess the risk of whatever decisions or investments they are considering.
Financial forecasts are based on income statements, balance sheets and cash flow statements. The finance department can link these three reports to create what is known as a three-statement model—any change to the model affects the three statements. Other popular models include the discounted cash flow (DCF) model, merger and acquisition model, consolidation model, budget model, forecasting model and pricing model.
Why Is Modeling Important?
A finance team might build models as they create or revise their financial forecasts, which explains the frequent confusion between the two functions. But financial models serve other purposes, as well, to analyze both current operations and for long-term forecasting. Corporate development teams often use models when considering a potential acquisition, a divestiture or how to allocate capital to better understand how this might impact revenues and expenses. They may also use it to decide if and where to open or close facilities, outsource certain operations or add/reduce headcount. Models can also help determine the impact of raising or decreasing prices for various products or services.
During the COVID-19 pandemic in 2020, many planners had to create new financial models to adjust their short-term forecasts based on the sudden and dramatic economic downturn. Integrated budgeting and planning tools helped many companies adapt quickly and mitigate the impact of COVID-19. It also helped them see the effects of various possible outcomes related to the pandemic.
Now that these tools have become more powerful and easier to use, modeling has moved beyond just finance. Marketing, sales, supply chain and procurement professionals increasingly create models to inform their strategies, decisions and recommendations to executives.
Financial Forecasting vs. Financial Modeling
- Finance professionals build forecasts and models with the objective of offering a reasonable estimate of how a business will perform, including both revenue and expenses. They develop this estimate based on historical and presumed future factors.
- Forecasts and models typically use the same historical data and projections of variable costs to predict a company’s revenue.
- Similar audiences analyze the output of both financial forecasts and models, including investors, lenders and corporate planning and budgeting teams.
- The financial forecast is the baseline representation of predicted cash flow and expenses for a given accounting period. It’s represented in pro forma income statements, balance sheets and cash flow statements.
- Finance professionals build financial models using analytical tools that allow them to understand how different internal and external events might impact cash flow and expenses.
- Those who create financial models are often doing so for a specific reason, such as seeking investors, analyzing the impact of finite business decisions and the risk factors associated with each. Forecasts are done on a regular basis to help with planning and budgeting.
Financial Modeling vs. Financial Forecasting Comparison
|Financial Forecasting||Financial Modeling|
|Business Purpose||The finance department typically creates forecasts to build more accurate and realistic budgets.||In the budgeting process, models can help planners and analysts consider best- and worst-case scenarios.|
|Audience||Forecasts appear on income and cash flow statements and balance sheets.||Typically for internal decision makers and not necessarily shared with investors or creditors.|
|Data Inputs||Forecasts are built on historical and forward-looking data to provide expected revenue and expenses for an upcoming accounting period, usually a quarter or fiscal year.||Models use forecasts and other data to simulate how any specific decision(s) might impact business performance.|
|Who Does It?||Generally, operations and FP&A teams create forecasts to report planned expenses and revenues. Those numbers then guide decision-makers’ expectations and decisions.||Anyone with the skills and tools can create models for various reasons, ranging from refining or revising a forecast to performing research.|